Credit Suisse's notes on Russell 2000 have high coupon, short term, but knock-in is a risk

By Emma Trincal

New York, Oct. 21 - Credit Suisse AG, Nassau Branch's upcoming 7% callable yield notes linked to the Russell 2000 index should appeal to investors who are "mildly bullish, neutral or mildly bearish" on the small-cap benchmark, according to an FWP filing with the Securities and Exchange Commission.

A financial adviser said that the coupon was attractive for a short-term product but that investors had to be comfortable with the risk present due to the knock-in feature. His approach to analyzing the deal was to compare the potential risk and payoff with an option strategy.

The notes will mature Feb. 3, 2011, the filing said.

The 7% annualized coupon will be payable monthly.

If the index closes at or below the knock-in level - 80% of its initial level - during the life of the notes, the payout at maturity will be par plus the index return, subject to a maximum payout of par. Otherwise, the payout will be par.

The notes will be callable on any interest payment date.

The financial adviser said that the coupon offered by the notes - 7% annually, or 1.75% for the three-month term - was attractive and that the reward warranted some risk.

"You do have to take some risk to get that coupon," he said.

In this deal, investors have to be willing to lose some or all of their investment if a knock-in event occurs, the prospectus stated.

"Yet I wouldn't want to use this strategy," the adviser said. "I just don't think the 1.75% for three months is that good of a return for the downside risk.

"I think the notes follow a market-neutral strategy. You get a good protection if there is no knock-in. But if there is a knock-in and your underlying drops by more than 20%, you can lose a substantial amount."

He explained that for investors in the notes, the best scenario is that they get their principal back at maturity, since they get paid the coupon, in a similar way as a reverse convertible and regardless of the level of the underlying index.

On the other hand, the worst scenario for investors is that they lose some of their principal, and such outcome happens when two conditions are met:

• A knock-in event occurs during the life of the notes; and

• The index at maturity closes below its initial value.

The adviser said that the notes make sense for investors who see the price trading range bound.

However, he said that if he held this view, he would be more inclined to substitute the notes for a cash-covered put writing strategy.

Writing a covered put

"For any reverse convertible-like structure, I like to price out the option," he said.

"I would look at the iShares Russell 2000 index [exchange-traded fund], symbol IWM, and look at a January put."

By selling the put with a strike price that is the equivalent of 80% of the underling's initial price, this adviser hopes to make money with the premium paid to the put seller.

Since the notes also offer a fixed return via the coupon, the put strategy would be preferable only if it limits the risk on the downside, he explained.

"My risk is if the ETF finishes at maturity below the strike price. In that case, I get put. I have to buy at a higher price," he said.

"I would sell a put with an 80% strike. I would pocket a premium, the equivalent of my 1.75% coupon on three-month.

"I would opt for a cash-covered put, that is, I would keep the money at hand in case I get put and have to buy IWM if I breach the strike."

Downside risk

"This deal is similar to a reverse convertible in that you get your coupon no matter what. But what you need to look at is how the downside risk compared to a put strategy. We always like to compare those deals with the options. That's the first thing we do," he said.

The adviser assumed first, the occurrence of a knock-in event during the life of the notes and then a 10% drop in the index at maturity.

"With the notes, you lose 10% because the index fell by more than 20% during the term - that's the knock-in - and because it ends up lower than the initial price. You have a 1.75% coupon. So your net loss is 8.25%.

"With my cash-covered put, I don't lose any principal because I am above the strike. The index is down 10%, not 20%. So I get par plus my coupon. My return is 1.75%. I get to keep my coupon.

"I would rather use the put because it gives me a harder buffer. I only lose when I get put, that is, if the shares close below the strike. With the notes, a knock-in event triggered anytime puts me at a greater risk. I am going to lose principal if the index finishes lower than the initial price, not if it finishes lower than the strike. I have less protection."

The adviser said that based on the terms of the deal, he would not pursue the trade.

"I only think the put strategy is a better alternative because I have a greater potential to keep my coupon.

"And while I'm better off with the covered put as I take some of the risk off the table, I don't eliminate the risk.

"In both strategies, I have a 1.75% payout. Is this payout worth taking on downside risk? It depends on the investor. In the fixed-income market, 1.75% is a decent payout. But I'm not sure the risk-return trade-off works out for me either way."

The notes (Cusip 22546ED50) are expected to price Oct. 29 and settle Nov. 3.

Credit Suisse Securities (USA) LLC is the underwriter.

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